Capital Budgeting

CHAPTER -1

INTRODUCTION

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1. INTRODUCTION

A Budget is a comprehensive plan of action which expressed in

physical and financial terms. It is a blue print of the company's financial

estimates for the future. Budgeting forms the most important part of the

planning function. It 's a system of planning and control covering all the

segments of an organization and also giving a sense of direction to the

goals and objectives of an organization. Budget constitutes the principal

instrument for projecting the future cost revenues, which form an essential

part of the management accounting and the foundation of an organization's

financial control.

A budget system should be such that it becomes

imperative for the management to establish goals and objectives, define

policies, allocates resources, set targets, and try to take corrective action

if there are any deviations. A management is said to be effective if it can

accomplish the objectives efficiently with minimum amount of resources

utilization.

In order to attain these set goals within a given set of constraints is

a difficult job; hence with the help of a proper budget one can achieve the

organization goals and objectives.

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DEFINITION:

The term capital budgeting refers to "long term planning for

proposed capital outlay and their financing. It includes raising long term

funds and their utilization. It may be defined as a firms formal process of

acquisition and investments of capital. It also defined as decision making

process by which the firm evaluates the fixed assets.

CONCEPT OF BUDGET:

"A budget is a financial and quantitative statement. Prepared and

approved prior to a defined period of time, of be pursued during that

period for the purpose of attaining a given objective". It may include

income, expenditure and the employment of capital". in other words, a

budget is a systematic plan for the better utilization of man, machine,

material and money. In a business organization a budget represents an

estimate of the future cost and revenues.

ESSENTIAL FEATURES OF A BUDGET:

1. It 's a written plan of activities for future period of time.

2. It is expressed in quantitative form, physical or monetary units or

both.

3. It relates to the income and expenditure of individuals functions of

the business.

4. It is prepared for a definite period of time, usually for one year.

5. It relates to future period for the objectives or goals have already

been laid down.

6. It is prepared in advance and is derived from the long-term strategy

of the organization .

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OBJECTIVES OF A BUDGET:

Budget serve has a "Blue print" of the desired plan of action.

Budget helps in reduction of wastage and losses by revealing them

in time for corrective action.

Budgets serve as means of communication. The organization

communicates the policies and targets to the managers in the

organization and all the responsible to carry out the plan.

Budget serves as the benchmark for the controlling ongoing

operation.

Budgeting facilitate centralized control with delegated authority and

responsibility.

Budgeting brings out the efficiency and improvement in the work of

the organization as all the details are clearly spelled out.

The capital budgeting decisions are difficult to make because

it involves the assessment of future events which are difficult to

ascertain.

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SCOPE OF THE STUDY

The scope of the present study includes the following:

Understanding the importance of capital budgeting in Dr. Reddy’s

Laboratories Ltd

Evaluating an investment proposal of setting up facility at Dr. Reddy’s

Laboratories Ltd for manufacturing NEW DRUG 30 for supplies directly from

bulk units.

RESEARCH METHODOLOGY

The primary data needed for the project analysis has been collected through

unstructured interviews and discussions conducted with the finance department.

The secondary sources of data are annual reports, brochures and web resources. A

case study approach has been used for the study of capital budgeting at Dr.

Reddy’s Laboratories Ltd

LIMITATIONS

The study was conducted with the data available and analysis was made

accordingly.

Due to the confidential financial records, the data is not exposed so the

study may not be detailed and full fledged.

Since the study is based on the financial data that are obtained from the

company’s financial statements, the limitations of financial statements shall be

equally applicable.

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ASSUMPTIONS

Sales and operational levels have been assumed to evaluate the investment

proposal of manufacturing NEW DRUG 30 in Dr. Reddy’s Laboratories Ltd.

CAPITAL BUDGETTING PROCESS

The process of capital budgeting involves generally the following steps:-

1. INVESTMENT SCREENING AND SELECTION :

Project consistent with the corporate strategy are identified.

But projects don't simply walk into corporate headquarters. he firm must

have some system for seeking or generating investment opportunities.

Identifying investment opportunities is not necessarily the task of the

financial managers.

2. THE CAPITAL BUDGET PROPOSAL :

A capital budgeting is proposed for the project surviving the

screening the and selection process. The budget lists the recommended

projects and the rupee amount of investment needed for each. This

proposal may start as an estimate of expected revenues and costs.

3. BUDGETING APPROVAL AND AUTHORIZATION:

Projects included in the capital budget are authorized, allowing further fact gathering and analysis, and approved, allowing expenditures for the projects, the projects are authorized and approved at the same time.

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4. PROJECT TRACKING:

After a project is approved, work on it begins. The manager reports periodically on its expenditures, as well as on the any revenues associated with it . This is referred to as project tracking, the communication link between the decision makers and the operating management of the firm.

5. POST- COMPLETION AUDIT :

Following a period of time, perhaps two or three years after approval, project are reviewed to see whether they should be continued. This re-evaluation is referred to as a post- completion audit. Thorough post-completion audits are not usually performed on every project since that would be too time consuming

TYPES OF CAPITAL BUDGETING DECISIONS:

REPLACEMENT

DIVERSIFICATION

RESEARCH AND DEVELOPMENT

EXPANSION

MISCELLINIOUS

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TECHNIQUES OF CAPITAL BUDGETING:

Non-discounted cash flow criteria Discounted cash flow criteria

Payback period

Accounting rate of return

Net present value

Internal rate of return

profitability index

Discounted payback period

Net terminal value

TRADITIONAL/NON-DISCOUNTING TECHNIQUES:

PAY BACK PERIOD:-

The payback period is one of the most popular and widely recognized traditional methods of evaluation investment proposals. It is defined as the number of years required to recover the original cash outlay invested in a project. If the project generates constant annual cash flows, the payback periods can be computed by dividing cash outlay by the annual cash inflow.

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Payback period = Initial Investment / Annual cash inflow

AVERAGE/Accounting Rate of Return:-

The Accounting rate of return (ARR) is known as average rate of return and also return on investment (ROI). It is found out by dividing the average after tax profit by the average investment. The average investment would be equal to half of the original investment of it is depreciated constantly. Alternatively , i t can be found out dividing the total of the investments book value after depreciation by the life of the project.

Accounting rate of return = Average income / Average investment

Average investment = Original investment - Scrap value / 2

ACCEPTANCE RULE:

This method will accept all those project whose ARR is higher than the minimum rate established by the management and reject those project which have ARR less than the minimum rate. This method would rank a project as number as project as number one of it has higher ARR and lowest rank would be assigned to the project with lowest ARR.

Discounted cash flow criteria:

PARIECULARS 1 2 3 N

Cash/revenue --- --- --- ---

(-) Cash operating

--- --- --- ---

CIBT --- --- --- ---

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(-) Depreciations

--- --- --- ---

Taxable income --- --- --- ---

(-) Tax (EAT) --- --- --- ---

(+) Depreciations

--- --- --- ---

CIAT --- --- --- ---

(+) Salvage value in Nth year

--- --- --- ---

(+) Recovary of the W/C

--- --- --- ---

NET PRESENT VALUE:-

The net present value (NPV) method is the classic economic method of evaluating the investment proposals, It is method in which we can convert future cash profits to today's cash profit based on the interest rate is nothing but cost of capital or the inflation rate or the rate expected by the investors. If the rate of interest is not given, in India maximum return expected is 10% so find out the NPV at10% only. If the NPV is +ve, we will get projects. Accordingly accept/reject decision will be taken.

Net present value = (summation of present value of cash inflows in each year) – (the summation of present values of the net present value of two mutually exclusive project X and Y.)NPV < 0 RejectNPV > 0 Accept

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Net Present Value Decision Rule :

If… This means that And you…

NPV>0 The investment is expected to increase share holder wealth.

Accept the project

NPV<0 The investment is expected to decrease share holder wealth.

Reject the project

NPV=0 The investment is expected not to change share holder wealth.

Should indifference between accepting & rejecting the project.

Internal rate of return:-

The second discounted cash flow or time adjusted method for apprising capital investment decisions is the internal rare of return (IRR) method. This technique is also known as yield on investment, marginal efficiency of capital, marginal productivity of capital. The internal rate of return is usually the rate of return that a project earns. It is defined as the discount rate which equates the aggregate present value of net cash flows which the aggregate present value of cash flows outflows of a project.

IRR = lower rate of return + present value of cash inflows at lower rate - present value of investment * Difference between the dis rate chosen

Diff.btw present value

Acceptance of project:

Accept - if IRR > cost of capital

Reject - if IRR < cost of capital

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INTERNAL RATE OF RETURN DECISION RULE:

The internal rate of return of decision rule is to invest in a project if it provides a return greater than the cost of capital. The cost of capital. The cost of capital. in the context of the IRR, is a hurdle rate the minimum acceptable rate of return,

Internal rate of return (IRR) is that rate which the discounted cash inflows match with discounted cash outflows.

IRR DECISION TABLE :

If… This means that… And you…

IRR>1 The investment is expected to increase shareholder wealth.

Accept project

IRR<1 The investment is expected to decrease the shareholder wealth.

Reject project

IRR=1 Investment is expected not to change shareholder wealth.

Should be in difference between accepting or rejecting the project.

Profitability Index (PI):

Another time adjusted capital budgeting technique is profitability index or benefit cost of ratio. It is similar to the NPV approach. The profitability index roach means the present value of returns per rupee invested, whistle the NPV is a based on the once between the future values of inflows and the present value of the cash outlays, A major dis-advantages of NPV method that being and absolute measure, it is not reliable method to evaluate projects requiring different initial investments. The PI method provides a solution to this kind of problem. It may be defined as the ratio which is obtained dividing the present value of future cash inflows by the present value of cash outlays.

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PI = Present value of cash inflows / present value of cash outflows * 100

ACCEPTANCE OF THE PROJECT:

If the present value sum total of the compounded reinvested cash inflows (PVTs)is greater than the present value of the outflows (PVOs) , the project is accepted if:

PVTs > PVOs ACCEPT

PVTs < PVOs REJECT

Profitability Index Decision Rule :

If … This means that… And you…

P1>1 The investment return more than Rs. 1 p/v for every Rs.1 invested.

Should accept the project

P1<1 The investment return less than Rs. 1 p/v for every Rs.1 invested.

Should reject the project

P1=1 The investment return Rs. 1 p/v for every Rs.1 invested.

In difference between accept and reject project

Net Terminal Value Method (NTV) it can be represented as

NTV = PVTs - PVO

If the NTV is positive, accept the project. If the NTV is negative, reject the reject. The NTV method is similar to NPV method. Initially the values are compounded, and in the later they are discounted. Both the method wills the same results. The same interest rates are used for both discounting and compounding.

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CHAPTER-2

REVIEW

OF

LITERATURE

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2 REVIEW OF LITERATURE

2.1 Investment Decisions

One of the basic questions faced by financial managers is: How should

the scarce resources of the firms be allocated to get the maximum value for the

firm? This refers to investment decisions, which deal with investment of firm’s

resources in Long term (fixed) Assets and Short term (current) Assets or Capital

Budgeting Decisions and Working Capital Management.

Capital budgeting is a decision making process for investment in

assets that have long term implications, affect the future growth and profitability

of the firm and basic composition and assets mix of the firm. It involves

Measuring the benefits and costs associated with each alternative option in

terms of incremental cash flows,

Evaluating different proposals in the light of return expected by the

investors of the firm and the return promised by the proposal, and

Applying different techniques to select an alternative with the objective of

maximization of value of the firm.

Typically, Capital Budgeting decisions involve rather large cash

outlays and commit the firm to a particular course of action over a relatively long

period and consequently, every care should be taken care of. The future risks and

uncertainties should be incorporated in the evaluation procedure so that future

cash flows occur as they are intended to be. (R.P.Rustagi 2005, p367)

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1 Features of Capital Budgeting

The exchange of current funds for future benefits.

The funds are invested in long-term assets.

The future benefits will occur to the firm over a series of years

(I.M.Pandey 2005,p141)

2.1.2 Significance of Capital Budgeting

The significance of capital budgeting may be stated as follows.

INVOLVEMENT OF HEAVY FUNDS: Capital budgeting decisions require large capital outlays. It is, therefore absolutely necessary that the firm should carefully plan its investment programmes so that it may get the finances at the right time and they are put to most profitable use. An opportune investment decision can give spectacular results. On the other hand, an ill-advised and incorrect decision can jeopardize the survival of even the big.

MINIMUM RATE OF RETURN ON INVESTMENT :

The management expects a minimum rate of return on the capital investment. The

minimum rate of return is usually decided on the basis of the cost of capital. For example,

if the cost of capital is 10%, the management will not like to accept a proposal, which

yields a rate of return less than 10%. The project s giving a yield below the desired rate of

return will therefore be rejected.

CUT-OFF POINT:

The cut-off point refers to the point below which a project would not be accepted. For

example, if 10% is the desired rate of return, the cut-off rate is 10%. The cut-off point

may also be in terms of period. For example, if the management desires that the

investment in the project should be recouped in three years, the period of three years

would be taken as the cut-off period.

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RETURN EXPECTED FROM THE INVESTMENT :

Capital investment decisions are made in anticipation of increased return in the future. It

is therefore very necessary to estimate the future return or benefits accruing from the

investment proposals. There are two proposals available for quantifying benefits from

capital Investment decisions. They are:

o ACCOUNTING PROFIT: The term accounting profit is identical with

income concept used in accounting.

o CASH FLOWS: In this depreciation charges and other amortization

charges on the fixed assets are not subtracted from gross revenue because no

cash expenditure is involve.

Evaluation Techniques Of Capital Budgeting

Evaluation Techniques of Capital Budgeting are classified into two types:

1. TRADITIONAL TECHNIQUES:

Average rate of return

Pay-back period

2. MODERN OR TIME ADUSTED OR DISCOUNTED CASH FLOW

(DCF) TECHNIQUES:

Net present value (NPV)

Internal rate of return (IRR)

Profitability index (PI) or Benefit-cost ratio (B/C RATIO)

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Accept if ARR > minimum rate

2.3.1 Traditional Techniques

2.3.1.1 Average Rate Of Return (ARR)

The average rate of return (ARR) method of evaluating proposed capital

expenditure is also known as the accounting rate of return method. It is based upon

accounting information rather than cash flows. There is no unanimity regarding the

definition of the rate of return. There are a number of alternative methods for calculating

the ARR. The most common usage of the average rate of return (ARR) expresses it as

follows:

ARR = Average annual profits (after dep & taxes) * 100

Average investment over the life of the project

ACCEPT-REJECT RULE:

With the help of the ARR, the financial decision maker can decide whether

to accept or reject the investment proposal. As an accept-reject criterion, the actual ARR

would be compared with a predetermined or a minimum required rate of return or cut-off

rate.

2.3.1.2 Pay Back Period (PBP)

The pay back method (PB) is the second traditional method of capital

budgeting. It is the simplest and, perhaps, the most widely employed, quantitative method

for appraising capital expenditure decisions. This method answers the question: How

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Accept if PB < standard payback

Reject if PB < standard payback

many years will it take for the cash benefits to pay the original cost of investment,

normally disregarding salvage value? Cash benefits here represent CFAT ignoring

interest payment. Thus the pay back method measures the number of years required for

the CFAT to pay back the original outlay required in an investment proposal.

Investment PB =

Constant annual cash flow

ACCEPT-REJECT CRITERION:

The payback period can be used as a decision criterion to accept or reject

investment proposals. One application of this technique is to compare the actual pay back

with a predetermined pay back that is the pay back set by the management in terms of the

maximum period during which the initial investment must be recovered. If the actual

payback period is less than the predetermined pay back, the project would be accepted; if

not it would be rejected.

2.3.2 Discounted Cash Flow (DCF)/Time -Adjusted (TA) Techniques

The distinguishing characteristic of the DCF capital budgeting is that they

take into consideration the time value of money while evaluating the cost and

benefit of a project.

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NPV>ZERO (accept)

NPV<ZERO (reject)

NPV=ZERO (indifferent)

2.1.2.1 Net Present Value (NPV)

The first DCF/PV technique is the NPV. NPV may be described as the

summation of the present values of cash proceeds (CFAT) in each year minus the

summation of present value of the net cash outflows in each year. Symbolically,

the NPV for projects having conventional cash flows would be:

NPV = - Initial investment

Where ct = cash flow at the end of year t

n = life of the project

r = discount rate

STEPS FOR COMPUTATION OF NPV:

Firstly an appropriate rate of interest should be selected to discount cash

inflows. It is generally known as cost of capital, which is equal to the

minimum rate of return expected by the firm on investment proposals.

Secondly, the present value of cash inflows and cash outflows should be

computed using the cost of capital as discounting rate.

Finally, the present value of cash outflows is subtracted from present value

of cash inflows to get NPV.

ACCEPT-REJECT CRITERION:

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2.1.2.2 Internal Rate Of Return (IRR)

The second discounted cash flow (DCF) or time adjusted method for

appraising capital investment decisions is the internal rate of return (IRR) method. This

technique is also known as yield on investment, marginal efficiency of capital, marginal

productivity of capital, rate of return, and time-adjusted rate of return and so on. Like the

present value method, the IRR method also considered the time value of money by

discounting the cash streams.

The internal rate of return is usually the rate of return the project earns. It

is defined as the discount rate(r) which equates the aggregate present value of the net cash

inflows (CFAT) with the aggregate present value of cash outflows of a project. In other

words, it is that rate which gives the project NPV as zero.

COMPUTATION OF IRR

In computing IRR, future cash inflows are discounted in such a way that

their total PV is just equal to the PV of total cash outflows. The time schedule of

occurrence of the future cash flows is known but rate of discount is not. This discount rate

is rtained by trial and error method. This rate of discount so calculated, which equates the

PV of cash inflows with PV of cash outflows is known as IRR.

Investment =

Where ct = cash flow at the end of year t

r = internal rate of return (IRR)

n = life of the project

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Accept if IRR > k

Reject if IRR < k

Project may be accepted if IRR = k

ACCEPT-REJECT CRITERION

The use of the IRR, as a criterion to accept capital investment decisions,

involves a comparison of the actual IRR with the required rate of return also known as the

cut-off rate or hurdle rate. The project would qualify to be accepted if the IRR(r) exceeds

the cut-off rate (k).If the IRR and the required rate of return are equal, the firm is

indifferent as to whether to accept or reject the project.

2.1.2.3 Profitability Index (PI) Or Benefit-Cost Ratio (B/C Ratio)

Yet another time-adjusted capital budgeting technique is profitability index

(PI) or benefit cost ratio (B/C RATIO) .It is similar to NPV approach. The

profitability index approach measures the present value of returns per rupee

invested, while the NPV is based on the difference between the present value of

future cash inflows and the present value of cash outlays. A major shortcoming of

the NPV method is that, being an absolute measure, it is not a reliable method to

evaluate projects requiring different initial investments. The PI method provides a

solution to this type of problem. It is, in other words, a relative measure. It may be

defined as the ratio which is obtained by dividing the present value of future cash

inflows by the present value of the cash outlays.

Symbolically,

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PI>1 (ACCEPT)

PI<1 (REJECT)

PI=1 (INDIFFERENT)

PI = Present value of cash inflows

Present value of cash outflows

This method is also called as benefit cost ratio because the numerator measures

benefit and the denominator cost. More appropriate description would be present

value index.

ACCEPT-REJECT CRITERION

Using the B/C ratio or the PI, a project will qualify for acceptance

if its PI exceeds one. When PI equals 1; the firm is indifferent to the project.

When PI is greater than, equal to or less than 1, the net present value is greater

than, equal to or less then zero respectively. I n other words, the NPV will be positive

when the PI is greater than 1; will be negative when the PI is less then one. Thus, the

NPV and PI approaches give the same result regarding the investment proposals.

(I.M.Pandey 2005,p143-152)

2.1.2.4 Selecting the appropriate Technique

All the techniques discussed above attempt to allocate the firms resources

in the most efficient way, although they sometimes do not agree on the right choice to

make. Each of these techniques has its own decision rule.

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It may be logically stated that much of a choice of the technique depends upon

the situational factors particularly the firm, the funds availability and the relative

importance of a decision etc. Moreover, different firms and different finance

managers may have different acceptance standards. As the circumstances surrounding

may vary over a wide range, any attempt to prescribe the best technique will be futile.

However the following generalization can be made.

The Payback technique ignore the time value of money, the timings of the

cash flows and also the cash flows occurring after the payback period and hence it fails to

be a sound technique. It is uncommon for firms to make capital budgeting decisions

solely on the basis of PB technique. However, firms are likely to employ the PB

technique as the secondary rule either (i) as a constraint in decision making or (ii) as a

way to choose between projects that score equally well on the primary decision rule

The ARR technique would have been a good evaluation

technique if the objective had been profit maximization instead of wealth maximization.

It also ignores the time value of money, timings of return besides ignoring the cash

generations by tax shield of depreciation etc. Only in a case, when the firm is looking for

a return from an investment in terms of profits contributed, the ARR may be applied.

The PI technique can be appropriately used by those firms,

which, in view of the funds constraints, are looking for proposals, which will contribute

more per rupee spent. Also the finance manager can use the PI technique when he wants

to evaluate the effect of future cash flows. However, since the PI technique does not

consider the absolute accruals to the firms wealth by a proposal, it fails to be in line with

the objective of the wealth maximization.

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Both the basic discounted cash flow techniques ie the NPV and the IRR

impliedly enhance the wealth of the shareholders. These techniques are best suited for

firms, which are working for the objective of wealth maximization, since these techniques

recognize the contribution generated by a proposal towards the wealth. These techniques

can be applied only if the firm is looking for the benefits being brought by the proposal to

the firm.

In particular, the NPV technique is most appropriate for firms

trying for the wealth maximization, by undertaking those projects which are expected to

generate maximum additional [present values. The NPV technique is also suitable to hose

firms, which are interested in ranking of various proposals in order of ‘addition’ expected

from these proposals. The NPV is the most clear indication of the additional value created

by a proposal. The NPV technique seems to be the most in line with the objective of

wealth maximization. As per the NPV technique, the value of the firm should increase as

it continues to add further projects with NPVs. The firm should take as many projects

with the positive NPV as possible

Obviously, none of the criteria is applicable to all the situations all the

time. A firm needs to use more than one criterion in evaluating any set of capital

budgeting proposals. It may rank different proposals as per the NPV technique but the

benefit per rupee invested (PI technique) may also be considered.(R.P.Rustagi 2005,

p436-437)

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CHAPTER-3

COMPANY PROFILE

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3 THE COMPANY

DR. REDDY’S LABORATORIES LTD was founded by Dr Anji Reddy, a

entrepreneur-scientist, in 1984. The DNA of the company is drawn from its founder and

his vision to establish India’s first discovery led global pharmaceutical company. In fact,

it is this spirit of entrepreneurship that has shaped the company to become what it is

today.

Dr Anji Reddy, having moved out of Standard Organics Limited, a

company he had successfully co-founded, started DR. REDDY’S LABORATORIES

LTD with $ 40,000 in cash and $120,000 in bank loan! Today, the company with

revenues of Rs.2,427 crore (US $546 million), as of fiscal year 2006, is India’s second

largest pharmaceutical company and the youngest among its peer group.

The company has several distinctions to its credit. Being the first

pharmaceutical company from Asia Pacific (outside Japan) to be listed on the New York

Stock Exchange (on April 11, 2001) is only one among them. And as always, Dr. Reddy’s

chose to do it in the most difficult of circumstances against widespread skepticism. Dr.

Reddy’s came up trumps not only having its stock oversubscribed but also becoming the

best performing IPO that year.

Dr. Anji Reddy is well known for his passion for research and drug

discovery. Dr. Reddy’s started its drug discovery programme in 1993 and within three

years it achieved its first breakthrough by out licensing an anti-diabetes molecule to Novo

Nordisk in March 1997. With this very small but significant step, the Indian

industry went through a paradigm shift in its image from being known as just

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‘copycats’ to ‘innovators’! Through its success, Dr. Reddy’s pioneered

drug discovery in India. There are several such inflection points in the company’s

evolution from a bulk drug (API) manufacturer into a vertically integrated global

pharmaceutical company today.

Today, the company manufactures and markets API (Bulk

Actives), Finished Dosages and Biologics in over 100 countries worldwide, in addition to

having a very promising Drug Discovery Pipeline. When Dr. Reddy’s started its first big

move in 1986 from manufacturing and marketing bulk actives to the domestic (Indian)

market to manufacturing and exporting difficult-to-manufacture bulk actives such as

Methyldopa to highly regulated overseas markets, it had to not only overcome regulatory

and legal hurdles but also battle deeply entrenched mind-set issues of Indian Pharma

being seen as producers of 'cheap' and therefore ‘low quality’ pharmaceuticals. Today, the

Indian pharma industry, in stark contrast, is known globally for its proven high quality-

low cost advantage in delivering safe and effective pharmaceuticals. This transition, a

tough and often-perilous one, was made possible thanks to the pioneering efforts of

companies such as Dr. Reddy’s.

Today, Dr. Reddy’s continues its journey. Leveraging on its ‘Low

Cost, High Intellect’ advantage. Foraying into new markets and new businesses. Taking

on new challenges and growing stronger and more capable. Each failure and each success

renewing the sense of purpose and helping the company evolve.

With over 950 scientists working across the globe, around the

clock, the company continues its relentless march forward to discover and deliver a

breakthrough medicine to address an unmet medical need and

make a difference to peoples’ lives worldwide. And when it does that, it would only be

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the beginning and yet it would be the most important step. As Lao Tzu wrote a long time

ago, ‘Even a 1000 mile journey starts with a single step.’

3.1 Business

Dr. Reddy's is a vertically integrated, global pharmaceutical

company with proven research capabilities and presence across the pharmaceutical value

chain. We manufacture Active Pharmaceutical Ingredients and Finished Dosage forms

and market them globally, with a focus on United States, Europe, India and Russia. In

addition, the drug discovery arm of the company conducts basic research in the areas of

diabetes, cardiovascular, inflammation and bacterial infection.

3.2 Board Of Directors

Dr. Reddy's has a board comprising of eminent individuals from

diverse fields. The board acts with autonomy and independence in exercising strategic

supervision, discharging its fiduciary responsibilities, and in ensuring that the

management observes the highest standards of ethics, transparency and disclosure.

Our Directors are experts in the diversified fields of medicine,

chemistry and medical research, human resource development, business strategy, finance

and economics. They review all information relating to significant business decisions,

including strategic and regulatory matters. Every member of the board, including the non-

executive directors, has full access to any information related to the company.

Committees appointed by the board focus on specific areas, and take

decisions within the authority delegated to them by the board. The committees also make

specific recommendations to the board on various matters from time-to-time.

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3.3 Corporate Governance

Dr. Reddy's long-standing commitment to high standards of

corporate governance and ethical business practices is a fundamental shared value of its

Board of Directors, management and employees. The Company's philosophy of corporate

governance stems from its belief that timely disclosures, transparent accounting policies,

and a strong and independent Board go a long way in preserving shareholders trust while

maximizing long-term shareholder value.

Good corporate governance flows out of the commitment of the

Management and the Board of Directors. When the commitment is backed by the

fundamental beliefs of maximizing value for stakeholders; transparent actions in the

business; values of a corporate; and mutual trust amongst all constituents of the business,

the organization transforms itself into a higher plane of leadership.

The forward-looking approach of Dr. Reddy's has always helped it, in

achieving the desired results. This approach has transformed the company's culture to one

that is relentlessly focused on the speedy translation of scientific discoveries into

innovative products. Dr. Reddy's commitment towards Corporate Governance started well

before law mandated such practices.

The company has identified and established its core purpose,

mission and core values for achieving corporate excellence. Dr. Reddy's believes in

crafting an environment where the parameters of conduct and behavior of the company

and its management is constantly aligned with the business environment.

The highlights of Dr. Reddy's Corporate Governance systems are

an independent Board of Directors following international practices, committed

31

management team, internal control systems and dissemination of information to various

stakeholders.

3.4 Awards & Accolades

The Appreciation Certificate of the District Collector for being the

“Best Clean Production Industry” for the year 2006 awarded to API Unit-V.

The CII "Southern Region Leadership Excellence Award" is won by Dr. Reddy's

for the year 2005.

5The CII "National Award for 'Excellence in Water Management" for the

year 2005 is won by both API Unit-II as well as API Unit-VI.

The Generics Unit of Dr. Reddy's achieves the new ISO 14001:2004

standard on 9th June, 2005.

The "Greentech Environmental Excellence Silver Award" for the year

2004-05 is won by API-Global Business Unit.

32

CHAPTER-4

DATA ANALYSIS

&

INTERPRETATION

33

4 DATA ANALYSIS & INTERPRETATION

4.1 Presentation & Analysis

The proposal is to set up facility for manufacturing NEW DRUG 30 for supplies

directly from bulk units.

Advantages:

Facility will be constructed in available structure with suitable

modifications and civil finishing’s.

New Drug 30 is manufactured in this unit.

Building is available without sacrificing any product.

Scope for expansion on service floor.

Built up area available is 250 M2.

QC support available with some augmentation in future.

Disadvantages:

May not possible to expand without major modifications or separate-

block.

Non – flameproof equipments – area classifications may not be met with

100%.

FEASIBILITY OF THE PROPOSED NEW DRUG 30 MANUFACTURING

FACILITY

Process Development Of Low Cost New Drug 30:

34

Use RM consumptions and makes of the expicients as used by contract

manufacturer

Process development to offer low cost New Drug 30 formula with Fluid

bed processor (FBP) technology.

Process will be developed with suitable alternative aqueous coating

materials.

Low Capital Investment:

Use of low automation and low cost capital equipments, which

competitors use with of course no compromise on quality of products.

HVAC – will be 5 microns filtered air once through.

Civil finishes will be suitable as per cGMP requirements.

FBP technology is relatively less labor intensive compared to Auto coater.

Existing Warehouses will be used. Suitable conditioned storage space will

be created for final product storage.

No effluent generation practically other than equipments washings.

OPERATIONAL REQUIREMENTS OF THIS PROJECT ON

EXECUTION:

The job involves key operations like manual drug coating and operation of

fluid bed processor.

API operators will be require to be trained in operations, which will be

done during the process of project executions. 3 – 4 weeks of training will be

sufficient. Thus additional manpower is required.

35

For Formulations Development support can be taken from FM –II or API

may have to have small setup to address smaller customizations required by

the markets.

QC/QA support will be given by Unit – III with some augmentation of

resources.

Quality Assurance and Regulatory affairs has given clearance for such a

set up in Unit –III.

Need for any specific licenses to sell New Drug 30 need to be verified

from Unit-III , however we are doing this activity from Unit-II currently.

PROPOSED INVESTMENT: 216 Lacs

RM cost Rs./ kg 485

Fixed Costs for New Drug 30 Per Month Rs/ month

Labour 100,833

Utilities 595,620

Repairs & Maintenance 41,667

Depreciation 166,667

Interest 162,000

1,066,787

Investment 2160

36

Net Income Per Annum

COMPUTATION OF NET INCOME PER ANNUM (Rs in Mns)

(1) Operation Level30Tn per month

(2) Sale Price Rs per Kg 900 850 800 750 700

(3) RM Cost Rs per Kg 485 485 485 485 485

(4) Sales Income [(1) * (2)] 27.00 25.50 24.00 22.50 21.00

(5)Variable Cost - RM Consumed [(1) * (3)] 14.55 14.55 14.55 14.55 14.55

(6) Contribution [(4) - (5)] 12.45 10.95 9.45 7.95 6.45

(7)Other Fixed Costs (Utilities, Labour, and QC Costs) 1.07 1.07 1.07 1.07 1.07

(8) Net Income [(6) - (7)] 11.38 9.88 8.38 6.88 5.38

(9)Total Net Income per annum [(8) * (12 months)] 136.56 118.56 100.56 82.56 64.56

(10)Investment 21.60 21.60 21.60 21.60 21.60

Table 1: Computation of Net Income Per Annum for 30 Tons per Month

37

COMPUTATION OF NET INCOME PER ANNUM (Rs in Mns)

(1) Operation Level20Tns per month

(2) Sale Price Rs per Kg 900 850 800 750 700

(3) RM Cost Rs per Kg 485 485 485 485 485

(4) Sales Income [(1) * (2)] 18.00 17.00 16.00 15.00 14.00

(5)Variable Cost - RM Consumed [(1) * (3)] 9.70 9.70 9.70 9.70 9.70

(6) Contribution [(4) - (5)] 8.30 7.30 6.30 5.30 4.30

(7)Other Fixed Costs (Utilities, Labour, and QC Costs) 1.07 1.07 1.07 1.07 1.07

(8) Net Income [(6) - (7)] 7.23 6.23 5.23 4.23 3.23

(9)Total Net Income per annum [(8) * (12 months)] 86.76 74.76 62.76 50.76 38.76

(10)Investment 21.60 21.60 21.60 21.60 21.60

Table 2: Computation of Net Income Per Annum for 20 Tons per

38

Average Rate of Return: Operation Level – 30 TNS PER MONTH

AVERAGE RATE OF RETURN (Rs in Mns)

Operation Level 30 Tns per month

Sale price Rs per kg 900 850 800 750 700

(1) Avg. Income 136.56 118.56 100.56 82.56 64.56

(2) Avg. Investment 10.8 10.8 10.8 10.8 10.8

ARR [(1)/(2)*100] 1264 1098 931 764 598

Table 3: Average Rate of Return for 30 Tons per Month

ARR = Average annual profits (after dep & taxes)

--------------------------------------------------------------- * 100

Average Investment

39

Graph 1: Average Rate of Return for 30 Tons per Month

Interpretations

The ARR more than the pre-specified rate of return is accepted. The

company requires a rate of return of 20%. Therefore, ARR of the project, which is

greater than 20% as specified by management, is accepted but most viable is at a

price of Rs.900 with respect to quantity of 30 Tns per month or 360 Tns per

annum

40

Average Rate of Return: Operation Level – 20 TNS PER MONTH

AVERAGE RATE OF RETURN (Rs in Mns)



(1) Avg. Income 86.76 74.76 62.76 50.76 38.76

(2) Avg. Investment 10.8 10.8 10.8 10.8 10.8

ARR [(1)/(2)*100] 803 692 581 470 359

Table 4: Average Rate of Return for 20 Tons per Month

ARR = Average annual profits (after dep & taxes) * 100

Graph 2: Average Rate of Return for 20 Tons per Month

Interpretations

The ARR more than the pre-specified rate of return is accepted. The

company requires a rate of return of 20%. Therefore, ARR of the project, which is

greater than 20% as specified by management, is accepted but most viable is at a

41

price of Rs.900 with respect to quantity of 20 Tns per month or 240 Tns per

annum

42

Payback Period: Operation Level – 30 TNS PER MONTH

PAYBACK PERIOD (Rs in Mns)



(1) Investment 21.6 21.6 21.6 2 1.6 21.6

(2) Net Income 136.56 118.56 100.56 82.56 64.56

Payback Period [(1)/ (2)] 0.16 0.18 0.21 0.26 0.33

Table 5: Payback Period for 30 Tons per Month

Investment

PB =


43

Graph 3: Payback Period for 30 Tons per Month

Interpretations

The Payback Period calculated for a project is to be compared with some

predetermined target period and Payback Period less than the target period is

accepted. Therefore, target period is 3 years and project less than that is accepted

but the viable is at Rs.900 with respect to the quantity of 30 Tns per month or 360

Tns per annum.

44

Payback Period: Operation Level – 20 TNS PER MONTH

PAYBACK PERIOD (Rs in Mns)



(1) Investment 21.6 21.6 21.6 21.6 21.6

(2) Net Income 86.76 74.76 62.76 50.76 38.76

Payback Period [(1)/ (2)] 0.25 0.29 0.34 0.43 0.56

Table 6: Payback Period for 20 Tons per Month

Investment

PB =


45

Graph 4: Payback Period for 20 Tons per Month

Interpretations

The Payback Period calculated for a project is to be compared with some

predetermined target period and Payback Period less than the target period is

accepted. Therefore, target period is 3 years and project less than that is accepted

but the viable is at Rs.900 with respect to the quantity of 20 Tns per month or 240

Tns per annum.

46

NPV: Operation Level – 30 TNS PER MONTH, Project Life – 5 Years

Net Present Value of the Project Investment @ discounting rate of 9% (Rs in Mns)



(1) Project Life5 years 5 Years 5 Years 5years 5years

(2) Present Value factor @ 9% 3.8 3.8 3.8 3.8 3.8

(3) Net Income 136.56 118.56 100.56 82.56 64.56

(4)

Present Value Net Income for Project Life

[(2) * (3)] 518.93 450.53 382.13 313.73 245.33

(5) Present Value of Investment 21.60 21.60 21.60 21.60 21.60

Net Present Value of the project [(4) – (5)] 497.33 428.93 360.53 292.13 223.73

Table 7: Net Present Value for 30 Tons per Month, Project Life-5 Years

NPV= NPV = - Initial investment

47

Graph 5: Net Present Value for 30 Tons per Month, Project Life-5 Years

Interpretations

NPV shows present value of the project. The project is accepted if its NPV

is positive and rejected if NPV is negative. Therefore, NPV of 30 Tns per month

or 360 per annum for project life of 5years is showing positive and viable is at a

price of Rs.900 where NPV is Rs.497.33 millions.

48





(1) Project Life10 years 10 years 10 years 10 years 10 years


(3) Net Income 136.56 118.56 100.56 82.56 64.56

(4)


[(2) * (3)] 842.58 731.52 620.46 509.40 398.34





49


Interpretations



or 360 Tns per annum for project life of 10years is showing positive and viable is

at a price of Rs.900 where NPV is Rs.820.98 millions.

50





(1) Project Life5 years 5 Years 5 Years 5years 5years


(3) Net Income 86.76 74.76 62.76 50.76 38.76

(4)


[(2) * (3)] 329.69 284.09 238.49 192.89 147.29





51


Interpretations





52





(1) Project Life10 years 10 years 10 years 10 years 10 years


(3) Net Income 86.76 74.76 62.76 50.76 38.76

(4)


[(2) * (3)] 535.31 461.27 387.23 313.19 239.15





53


Interpretations





54

IRR: Operation Level – 30 TNS PER MONTH, Project Life – 5

INTERNAL RATE OF RETURN FOR 5 YEARS (Rs in Mns)



Investment -21.60 -21.6 -21.6 -21.6 -21.6

Net Income per annum for 5years

1 136.56 118.56 100.56 82.56 64.56

2 136.56 118.56 100.56 82.56 64.56

3 136.56 118.56 100.56 82.56 64.56

4 136.56 118.56 100.56 82.56 64.56

5 136.56 118.56 100.56 82.56 64.56

IRR 632% 549% 465% 382% 299%

Table 11: Internal Rate of Return for 30 Tons per Month, Project Life-5 years

IRR = Investment =

55

Graph 9: Internal Rate of Return for 30 Tons per Month, Project Life-5 years

The project is accepted if IRR is more than the minimum rate, which is 9%

for this project. Thus, the project at a sale price of Rs.900 is getting greater than

40%, which is more than the minimum rate of return of 9% at a quantity of 30 Tns

per month or 360 Tns per annum for project life of 5yearS

56

IRR: Operation Level – 30 TNS PER MONTH, Project Life – 10 Years




Investment -21.60 -21.6 -21.6 -21.6 -21.6


1 136.56 118.56 100.56 82.56 64.56

2 136.56 118.56 100.56 82.56 64.56

3 136.56 118.56 100.56 82.56 64.56

4 136.56 118.56 100.56 82.56 64.56

5 136.56 118.56 100.56 82.56 64.56

6 136.56 118.56 100.56 82.56 64.56

7 136.56 118.56 100.56 82.56 64.56

8 136.56 118.56 100.56 82.56 64.56

9 136.56 118.56 100.56 82.56 64.56

10 136.56 118.56 100.56 82.56 64.56

IRR 632% 549% 466% 382% 299%

Table 12: Internal Rate of Return for 30 Tons per Month, Project Life-10 Years

IRR = Investment =

57

Graph 10: Internal Rate of Return for 30 Tons per Month, Project Life-10 Years

Interpretations

The project is accepted if IRR is more than the minimum rate which is 9%


40% which is more than the minimum rate of return of 9% at a quantity of 30 Tns

per month or 360 Tns per annum for project life of 10years.

58





Investment -21.6 -21.6 -21.6 -21.6 -21.6


1 86.76 74.76 62.76 50.76 38.76

2 86.76 74.76 62.76 50.76 38.76

3 86.76 74.76 62.76 50.76 38.76

4 86.76 74.76 62.76 50.76 38.76

5 86.76 74.76 62.76 50.76 38.76

IRR 402% 346% 290% 234% 178%

: Internal Rate of Return for 20 Tons per Month, Project Life-5 Years

IRR = Investment =

59


Interpretations





60





Investment -21.6 -21.6 -21.6 -21.6 -21.6


1 86.76 74.76 62.76 50.76 38.76

2 86.76 74.76 62.76 50.76 38.76

3 86.76 74.76 62.76 50.76 38.76

4 86.76 74.76 62.76 50.76 38.76

5 86.76 74.76 62.76 50.76 38.76

6 86.76 74.76 62.76 50.76 38.76

7 86.76 74.76 62.76 50.76 38.76

8 86.76 74.76 62.76 50.76 38.76

9 86.76 74.76 62.76 50.76 38.76

10 86.76 74.76 62.76 50.76 38.76

IRR 402% 346% 291% 235% 179%

Table 13: Internal Rate of Return for 20 Tons per Month, Project Life-10 Years

IRR = Investment =

61


Interpretations





62

P. I: Operation Level – 30 TNS PER MONTH, Project Life – 5 Years

PROFITABILITY INDEX FOR 5 YEARS (Rs in Mns)



(1) Project Life 5 years 5 years 5 years 5 years 5 years

(2) Present Value of factor @ 9% 3.8 3.8 3.8 3.8 3.8

(3) Net income 136.56 118.56 100.56 82.56 64.56

(4)Present Value Net Income for Project Life [(2) * (3)]

518.93 450.53 382.13 313.73 245.33

(5)Present Value of Investment

21.6 21.6 21.6 21.6 21.6

PI [(4)/ (5)] 24.02 20.86 17.69 14.52 11.36

Table 14: Profitability Index for 30 Tons per Month, Project Life-5 Years

Present value of cash inflows

PI =


63

Graph 13: Profitability Index for 30 Tons per Month, Project Life-5 Years

Interpretations

PI is 24.02, which is more than 1 and also NPV is positive hence the

project is more viable at a sale price of Rs.900 with respect to the quantity of 30

Tns per month or 360 per annum for a project life of 5years.

64







(3) Net income 136.56 118.56 100.56 82.56 64.56

(4)Present Value Net Income for Project Life [(2) * (3)] 842.58 731.52 620.46 509.40 398.34


21.6 21.6 21.6 21.6 21.6

PI [(4)/ (5)] 39.01 33.87 28.72 23.58 18.44



PI =


65


Interpretations

PI is 39.01 which is more than 1 and also NPV is positive hence the



66







(3) Net income 86.76 74.76 62.76 50.76 38.76



21.6 21.6 21.6 21.6 21.6

PI [(4)/ (5)] 15.26 13.15 11.04 8.93 6.82



PI =


67


Interpretations




68







(3) Net income 86.76 74.76 62.76 50.76 38.76



21.6 21.6 21.6 21.6 21.6

PI [(4)/ (5)] 24.78 21.36 17.93 14.50 11.07



PI =


69


Interpretations




70

CHAPTER- 5

FINDINGS

&

CONCLUSIONS

71

SUMMARY

The Project Report is based on the Capital Budgeting DR. REDDY’S

LABORATORIES LTD. The profile of the Company given briefly is collected

from the official website of the DR. REDDY’S LABORATORIES LTD &

brochures and the introduction, literature review on topic Capital Budgeting is

text based. The Capital Budgeting procedure at DR.REDDY’S is studied and the

same is applied with respect to the Pay back period, average rate of return, net

present value, profitability index and internal rate of return, calculated and

analyzed. Various tables and charts have been shown in order to compare the

increase or decrease of profitability of the project.

Capital Budgeting is an extremely important aspect of a firm's financial

management. Although capital assets usually comprise a smaller percentage of a

firm's total assets than do current assets, capital assets are long-term. Therefore, a

firm that makes a mistake in its capital budgeting process has to live with that

mistake for a long period of time.

72

FINDINGS

The following are the findings during the study of the project:

Average Rate of Return: As per the management, the minimum rate of

return expected is 20%. The project showing ARR greater than 20% is

accepted with respect to operation level 30 Tons or 20 Tons or 10 Tons per

month variation in sales price.

Pay Back Period: The project is accepted when Pay Back is less than 3

years which is standard payback period set by the management. The project,

which gives lesser payback period among difference in sales price and

quantity to be produced, is accepted and it is at price of Rs.900 whether the

quantities are 30 Tons or 20 Tons or 10 Tons.

Net Present Value: The net income of the project is discounted at the

minimum required rate of return – 9% and NPV is positive for different sales

price and at different operational levels.

Internal Rate of Return: The capital invested is getting return of more

than 40%, which is greater than 9% (cost of capital).

Profitability Index: The project showing PI more than 1 and also where

NPV is positive is taken up.

As sales price rises, demand factor also needs to be taken into

consideration.

73

CONCLUSIONS

It is concluded that the project is viable and profitable as the ARR is

getting more than 20%.

The PBP indicates that investment is fully recovered in short period

depending upon sales price and quantity.

NPV of the project is considered as better because of its higher Net Present

Value.

The IRR of the project is giving more than 40% Rate of Return whatever

be the sales price and operational level.

The PI more than 1 and where project shows NPV as positive is given first

preference.

The company has to sell at lesser price for more quantity produced and sell

at higher price for less quantity produced.

74

CHAPTER-6

BIBLIOGRAPHY

75

6 BIBLIOGRAPHY

Books

R.P. Rustagi, (2005), Financial Management Theory, Concepts and Problems

(Incorporating the Emerging trends in Indian Capital Market) (Second

Revised Edition), Galgotia Publishing Company, New Delhi

Prasanna Chandra, (2006), Financial Management Theory and Practice (Sixth

Edition), Tata McGraw-Hill, New Delhi

I. M. Pandey, (2005), Financial Management (Ninth Edition), Vikas Publishing

House Private Ltd, New Delhi

V.K. Saxena & C.D Vashist, (2002), Cost and Management Accounting, Sultan

Chand & Sons, New Delhi

a. Web Sites

www.drreddys.com

www.wikipedia.org/wiki/capital_budgeting

www.studyfinance.com

www.netmba.com/finance/capital/budgeting

www.eximfm.com/training/capitalbudgeting.doc

www.investorwords.com

76

http://www.investorwords.com/

http://www.eximfm.com/training/capitalbudgeting.doc

http://www.netmba.com/finance/capital/budgeting

http://www.studyfinance.com/

http://www.wikipedia.org/wiki/capital_budgeting

http://www.drreddys.com/

Capital Budgeting

Documents

Transcript of Capital Budgeting